Equations are omitted for technical reasons - download the original pdf

In a market economy the decisions on consumption are taken by households; decisions to produce are taken by firms. A market economy allows the price determinism mechanism to determine the output of goods and services, and what prices they are charged at. Productive efficiency is defined to be the production of goods and services at minimum cost. This means that it is not possible to produce more of any one good without producing less of another.Allocative efficiency, which is also called Pareto efficiency is defined to be a situation where it is not possible to improve one consumer's welfare without making another consumer worse off. All allocatively efficient economic systems are productively efficient, but not all productively efficient systems are allocatively efficient. According to economic theory, which is examined in closer detail in a further unit, when markets operate according to perfect competition, the result is both productive and allocative efficiency. Perfect competition arises when firms are small in comparison to the market, and they are consequently price-takers. In other words, the market determines the price at which the goods are sold. Each firm faces a perfectly elastic (horizontal) demand curve. In loose terms we can see why. In perfect competition firms are driven by competition towards optimal productive efficiency. The market ensures that the price each person pays for the goods produced is equal to the cost of producing them - that is, when the costs of capital (interest payments) are also taken into consideration. Let us examine the concepts of normal and supernormal profits.Normal profit is the rate of return required to keep an investor's money in a business. It varies from business to business as different businesses involve different levels of risk. When the risk is high, the return to the investors for placing their money with the business must also be high. Investors have the option of putting their money into the bank, or investing it in government bonds. The interest rate the government pays on investments is called the "base rate". Any rate of interest, over and above the base rate can be called a "premium". The rate of interest over and above the base rate that an investor must receive in order to invest in a possibly risky business is called the "risk premium". So, normal profit is the base rate + the risk premium. Supernormal profit is any profit over and above normal profit. Capitalists wish to find businesses that provide supernormal profits. Economists regard normal profits as an economic cost. From an economic point-of-view the normal profit is the cost of the capital invested in the business. It is, therefore, incorporated into the cost curve of the company. Any profits above normal profits are called economic profits, abnormal profits or supernormal profits. All the terms mean the same thing. The theory shows that companies in perfect competition only make normal profits. Imperfect competition arises when firms have some measure of control over the price they charge for the goods and/or services they produce, and this results in falling demand curve that exhibits some kind of inelasticity. [Diagram goes here - download the original pdf to see it.] A demand curve exhibiting elasticity When demand is inelastic companies can charge prices that result in supernormal profits. These supernormal profits mean that companies are siphoning off profits and redistributing wealth and income from the consumer generally to the shareholders. In other words, where there are supernormal profits then there is also productive and allocative inefficiency. There are three market structures that lead to imperfect competition: these are, monopoly, oligopoly and monopolistic competition. So the existence of monopolies and the other market structures described here are likely to result in a misallocation of resources, in the sense that production becomes productively and allocatively inefficient.